Mortgages

How Does a Home Mortgage work?

Want to buy a home? Do you have the cash in the bank? If you're like most people, you probably don't. We go to banks and mortgage lenders and borrow the money to buy our homes. What would we do if those banks and mortgage lenders weren't around to sell us the money to buy our homes? The rental market would sure be booming!

In this article, we'll explain how the secret world of mortgages makes home ownership possible for so many people. We'll look at some of those confusing terms you always hear, like "escrow" and "amortization," we'll look at all the fees you pay, and we'll find out what the costs of the loan really are. You may be surprised at what you are actually paying for that modest house in the suburbs!

What is a Mortgage?

According to Webster's, a mortgage is "the pledging of property to a creditor as security for the payment of a debt." In plain terms, it is the legal contract that says if you don't pay the loan back (along with all of the fees and interest that are included with it), and then the lender can have your house.

In states following the "title theory," the lender holds the title to your house until the debt is completely paid off, and the lender will sell your house in order to get the money back if you can't make your mortgage payments. In states following the "lien theory," the mortgage holds a lien on your property and can foreclose said lien and sell your property in the event you default under the mortgage.

Your down payment is the lump sum you pay up front that reduces the amount of money you have to finance. You can put as much money down as you want, or you can sometimes pay as little as 3 to 5 percent of the purchase price. The more money you put down, though, the less you have to finance and the lower your monthly payment will be.

The mortgage payment is made up of:

Principal - This is the total amount of money you are borrowing from the lender (after you've made your down payment). It is the amount of money you are financing.

Interest - This is the money the lender charges you for the loan. It is a percentage of the total amount of money you are borrowing.

Taxes - Money to pay your property taxes is often put into an escrow account, meaning that the money is placed in the hands of a third party until it is time to pay or certain conditions are met. A portion of your property tax is added to your monthly mortgage payment and held in escrow until it is due.

Insurance - There are several types of insurance that can come into play when you get a mortgage. You'll have hazard insurance to protect against losses from fire, storms, theft, etc., and if your home is in a flood risk zone and you're getting a federally insured loan, you'll have to get flood insurance. Unless you have at least 20 percent equity in your home, you'll also have to pay private mortgage insurance (PMI). This can sometimes be pretty expensive, so it makes sense to put as much into your down payment as you can. (Equity is the portion of your home's value that you have already paid for.)

These pieces of your mortgage payment are referred to as PITI.

Mortgages are typically paid off in incremental payments that gradually chip away at the principal of the loan. This is called amortization. The portion of your payment that goes to pay the interest is much higher than the portion that goes to the principal -- at least for the first several years.